The Newly Renovated Housing Bubble

Includes: ITB, PKB, XHB
by: Edward Moseley

Ample articles have recently pronounced that the housing recovery is well on its way. Most appear very surprised at the increase in housing prices, or enthusiastically discuss the recent increase in demand. While this may be true in the short- to mid-term, a contrary view would hold that there will be two times in the first half of this century that the U.S. will see the boom and bust cycle manifest itself in the housing sector, that there is no doubt what has been recently called the housing recovery is nothing more than a reflation of the housing bubble that burst in late 2007.

It is true that some believe that the housing recovery is an organic one, and will buoy housing prices ever nearer to their highs during the last bubble. Unfortunately, there is compelling evidence that would indicate that it is simply the formation of an asset bubble that cannot be maintained and must burst and be liquidated - again.

With the announcement of QE3 and QE4 thereafter, the market got the cue that it was time to invest in housing, as ample demand was most certainly on its way. This can be seen in the amount of new privately owned housing units started since QE3 was announced on September 13, 2012, as well as total private construction spending. In fact, home builder confidence is at its highest since 2006. (Note: Charts begin at the end of the prior recession, June of 2009, to show preceding economic data)

Meanwhile, we see the 30-Year conventional mortgage rate, during a period of relative market uncertainty, at its lowest since the official end of the last recession in June of 2009. This same interest rate is meant to indicate the abstention of consumption of the inputs necessary to complete the projects being purchased, or, in other words, that people have not already put into use the land, labor and capital equipment required to produce a house or some other structure. Today, as per Federal Reserve policy, the interest rate creates the supply of money, rather than the interest rate being an indicator of the supply of money, or more importantly, the resources that this money commands.

This asset bubble is nearly textbook - though the means of its creation is unprecedented in Federal Reserve history - the Federal Reserve is purchasing $40 billion per month in mortgage backed securities (as part of the purchase of $85 billion worth in U.S. Treasury and mortgage backed securities), precisely in order to lower the rate of interest on mortgages so that housing purchases or mortgage refinances will become more appealing. In artificially forcing down the interest rate, which is being done to a degree greater now than that which occurred during the prior bubble, demand for housing is being forced into the market by way of the central bank. This $40 billion in capital being allocated to the housing sector would not otherwise have been allocated there if not for the central bank's demand for mortgage backed securities.

It is important to note that $40 billion being allocated to the housing sector is not in itself a problem, it is the fact that this capital would not be allocated to the sector without the Federal Reserve monetizing it in this particular asset that should lead to cautious investment. Furthermore, the nominal value of $40 billion a month is not what should be focused on; it is the real capital goods that this money commands that is important. As demand for these same capital goods by investors increases, the price must raise in turn. Eventually, if the supply of these goods is not increased quite as fast as the money supply, additional credit will be required to finance the operations. If credit is contracted, downward pressure on the collateral occurs and there must be a bust.

Furthermore, the injection of credit into the market must necessarily lead to lending standards that are lower than they would be if not for the additional credit provided by the Federal Reserve. If the monetary supply were to be held constant, only a certain number of credit worthy market participants would receive the credit. If the Federal Reserve simply expands credit by adding to the money supply, the people receiving credit thereafter are the ones that would not have received it otherwise, as not all people are equally credit worthy.

With all this in mind, there is every reason to believe that the Federal Reserve will be able to revive the housing market from its 2009 lows, if that is what it seeks to do. Indeed, homebuilder confidence is at its highest since 2006. As long as the Federal Reserve is in the market for mortgage backed securities, the financial sector will continue to originate, securitize and sell them. It is only when the Federal Reserve decides to contract credit, and to allow interest rates to raise, that the housing recovery will come to an end.

Once more, there is ample evidence that the housing market is becoming a more profitable one to be involved in, either directly or in the capital markets as futures investors. Indeed, many did profit during the prior housing boom because they were able to flee the market before the bust. A chart of XHB, ITB, or PKB can prove the profitability, as shown by the clear upward trend since late 2011, of entering into the beginning of a bubble, as all are very similar to the trend shown below in XHB.

The gains are apparent, but as was mentioned above they may not last indefinitely. The prices will eventually reach a peak and then fall - perhaps precipitously as occurred in late 2007.

This asset bubble can indeed last for as long as the Federal Reserve is willing to allocate credit in its direction. As soon as the Federal Reserve announces that it will no longer purchase mortgage backed securities, interest rates will rise, demand will decrease for housing, and then the homeowners are in for it. The temporal relation of mortgages originated will be in that short period of the duration of QE3, leading to the massive cluster of error typical of economic cycles. Then the U.S. housing prices will drop, and the market will be back where it started - in the doldrums.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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